The Hoax of Modern Finance – Part 2: Indicators, Terminology, and Noise

Note to the reader: Over the next couple of weeks and months, I will be republishing the contents of my book, "Investing with the Trend," in article form here on my blog. I'm calling this series "The Hoax of Modern Finance" for reasons you will learn below. Hopefully, you will find this content useful. As always, let me know what you think in the comments area below the article. - Greg Morris, Nov. 2023

Indicators and Terminology You Should Be Familiar With

In this article, a lot of basic information is provided to assist you in understanding the remainder of this book. There are definitions, mathematical formulae, explanations of anomalies, historical events that affect the data, differing methods of calculation, and a host of other important information normally found in an appendix. It is of such importance to understand this material that it belongs prior to the discussion and not in the appendix, as is usually the custom.

There are basically four different indicator types: differences, ratios, percentages, and cumulative. Differences are most common and should be adjusted for time-independent scaling. As the number of issues increases over time, the scaling will expand, and thresholds that worked in the past will need to be adjusted. One way to do this is to normalize the indicator so the scaling is always between zero and 100. The following section covers many popular indicators and concepts that will help you understand them better when discussed later in the book.

Absolute value

In mathematical script, this is denoted with | | around the value in which you want to have its absolute value. Absolute value calculations ignore the sign (positive or negative) of the number. With breadth data, absolute value ignores market direction and only deals with market activity. The absolute value of +3 is 3, and the absolute value of −3 is also 3.

Accumulated/summed (∑)

This is the term used to add up a series of numbers. (See also cumulative.) For example, the advance-decline line is an accumulation of the difference between the advances and the declines. That difference is summed with each new day's difference added to the previous value. Also used with the term cumulate. In many formulae in this book, it is shown either as Previous Value + Today's Value or ∑.

Alpha

Alpha is a benchmark relative risk-adjusted measure. It is not simply excess return. If markets were truly efficient, then there would be no alpha.

Arithmetic/simple moving averages

To take an average of just about anything numerical, you add up the numbers and divide by the number of items. For example, if you have 4 + 6 + 2, the sum is 12, and the average is 12/3 = 4. A moving average does exactly this, but as a new number is added, the oldest number is removed. In the example above, let's say that 8 was the new number so that the sequence would be 6 + 2 + 8. The first 4 was removed because we are averaging only three numbers (3 period moving average). In this case, the new average would be 16/3 = 5.33. So by adding an 8 and removing a 4, we increased the average by 1.33 in this example. For those so inclined: 8 − 4 = 4, and 4/3 = 1.33.

In technical analysis, the simple or arithmetic average is used extensively. One thing that you should keep in mind is that with the simple average, each component is weighted exactly the same. This tends to make the simple average stale if it is used for large amounts of data. For example, the popular 200-day average means that the price 200 days ago carries the same weight or has the same effect on the average as the most recent price. It, therefore, is also much slower to change direction. See exponential average.

Average true range (ATR)

Average true range is the process of measuring the price action over a particular period, usually one day. Normally, this is done by just looking at the difference between the high and low prices of the day. However, ATR also includes the previous day's close so that if there is a gap, the price action also includes that movement.

Behavioral finance

A relative newcomer to the analysis of markets, this is the study of why investors do what they do. "Behavioral finance is the study of the influence of psychology on the behavior of financial practitioners and the subsequent effect on markets," to quote Martin Sewell (W6). "I think of behavioral finance as simply ‘open-minded finance,'" adds Thaler (A109).

Buy and hold

Buy and hold is the terminology used when discussing the act of making an investment and then just holding it for a very long time. This is more common than most would believe and can be a very bad decision during secular bear periods, which can last an average of 17 years.

Capitalization

Capitalization refers to the number of shares a company has outstanding multiplied by the price of the stock. Most market indices, such as the S&P 500, NYSE Composite, and the Nasdaq Composite, are capitalization-weighted, which means the big companies dominate the movement of the index.

Coefficient of determination

This measures the proportion of variability in a data set that is explained by another variable. Values can range from 0, indicating that zero percent of the variability of the data set is explained by the other variable, to 1, indicating that all of the variability in a data set is explained by the other variable. It is statistically shown as R2, which is nothing more than the square of correlation.

Correlation

A statistical measurement showing dependence between two data sets. Known in statistics and finance as R, it is used to determine the degree of correlation, noncorrelation, or inverse correlation between two data sets (often an issue such as a mutual fund and its benchmark).

Cumulative

Cumulative indicators can be differences, ratios, or percentages, where you are adding the daily results to the previous total. The advance-decline line is a good example of a cumulative indicator. It is sometimes referred to as accumulated or summed.

Detrend

A term to denote when you subtract the price from a moving average of the price. This will amplify the price relative to its smoothed value (moving average). To visualize this, pretend you had the ability to take both ends of the moving average line and pull it taut so that the price line falls into its same relative position to the now-straight moving average line. Doing this allows you to see cycles of a length greater than that of the number of periods used in the moving average.

Divergence

This is when an indicator and price do not confirm each other. At market tops, many times, the price will continue to make new highs, while an indicator will reverse and not make a new high. This is a negative divergence. A positive divergence is at market bottoms when the prices continue to make new lows, while the indicator does not and makes higher lows.

Drawdown

Drawdown is the percentage that the price moves down after making a new all-time high price. Drawdowns of greater than 20 percent are known as bear markets. This book will try to convince you that real risk is drawdown, not volatility, as modern finance wants you to believe.

Exponential moving averages

This method of averaging was developed by scientists, such as Pete Haurlan, in an attempt to assist and improve the tracking of missile guidance systems. More weight is given to the most recent data, and it is therefore much faster to change direction. It is sometimes represented as a percentage (trend percent) instead of by the more familiar periods. Here is a formula that will help you convert between the two:

K = 2/(N + 1) where K = the smoothing constant (trend percent) and N = periods

Algebraically solving for N: N = (2/K ) − 1

For example, if you wanted to know the smoothing constant of a 19-period exponential average, you could do the math, K = 2/(19 + 1) = 2/20 = 0.10 (smoothing constant) or 10 percent (trend) as it is many times expressed.

Here is something important in regard to exponential moving averages; by the nature of their formula, they will always change direction when they move through the price that is used to calculate them. This means that during an uptrend in prices and their exponential average, when the prices drop below the average, the average will immediately begin to decline. A simple or arithmetic average will not do this.

Filtered wave

Art Merrill says that this is an amplitude filter to remove the noise by filtering the data. He further states that the important swings in price action are clearly evident. Simply put, a filtered wave is a process of removing a predetermined percentage of noise.

Momentum

See Rate of change.

Normalize

This is a mathematical procedure to reduce the scaling of unlike data so it can be more easily compared. To normalize a series of data, one usually wants the resultant data to fall in a range from zero to 100. The easiest way to do this is by the following formula:

Current Value − Lowest Value in the Series

------------------------------------------------------------------------------- x 100

Highest Value in the Series − Lowest Value in the Series

Some of you might notice that this is similar to the formula for the %K Stochastic indicator, with the exception that, for stochastics, the highest and lowest values are set by the number of periods you want to use. Many indicators are served well by looking at their normalized values for a predetermined number of periods. For example, if there was a good identifiable cycle in the market being analyzed, the number of periods of that cycle length might be a good number to use for normalization. A number of the indicators in this book are normalized in that manner.

Oscillator

A term used to explain a number of technical indicators, such as rate of change, momentum, stochastics, RSI, and so on. These are all indicators that oscillate above and below a common value, which many times is zero. Other times, they oscillate between zero and 100.

Overbought/Oversold

These terms have got to be the most overused and misunderstood terms when talking about the markets. Overbought refers to the time in which the prices have risen to a level where it seems as if they cannot go any higher. Oversold is the opposite—prices have dropped to a point where it seems as if they cannot go any lower. Although this sounds simple enough, the term is usually based on someone's personal observation of price levels and not on sound analysis.

Overlay

This refers to the act of putting an indicator on top of another one. A simple example would be displaying a moving average of an indicator on the same plot. In this case, the indicator and its moving average would utilize the same scaling. Many times, an unrelated indicator can be overlaid on another using totally independent price scaling.

Peak

Peak is terminology referring to a peak in prices, usually easy to identify if looking at a price chart, but it does depend upon the time frame you are working with. See Trough.

Percentage

Percentage is generally better than a ratio because you are making the item relative to its related base. For example, the number of new highs by itself can be meaningful in the short term, but over long periods of time and with more and more issues traded, the relationship cannot remain consistent. If you took the number of new highs as a percentage of the total issues traded, then the scaling will always be from 0 to 100, and large amounts of data can be viewed with some consistency.

Rate of change

Used interchangeably with momentum, rate of change is looking at a piece of data relative to a like piece of data at an earlier time. For example, with stock data, a 10-day rate of change would take today's price and subtract or divide it by the stock's price ten days ago. If one takes the difference in price and then divides it by the older price, you will see percentage changes. Generally, it is not the value of the rate of change that is important but the direction and pattern associated with it. However, some oscillators have consistent levels that can be used as overbought and oversold. More often than not, rate-of-change seems to be in reference to the difference in values, whereas momentum is more often the ratio of values. The line shape will be the same; only the numbers that make up the line will be different.

Ratio

A ratio is when you divide one data component by another. This keeps them in perspective and will alleviate many of the problems associated with using just the difference. Sometimes, the numerator and denominator are not balanced, and you get a nonsymmetrical problem similar to what you get with the Arms Index. This is really not a problem as long as you are aware that it exists. Finally, a ratio of positive numbers (or similar signs) is always going to be greater than zero.

Real

This is commonly used when referring to data that has been adjusted for the effects of inflation. Most raw data contains the effects of inflation, so by removing inflation from the data, it is called real, such as the real S&P 500. Real = Nominal – Inflation.

Regression

This provides us with an equation describing the nature of the relationship between two variables, plus supplies variance measures that allow us to access the accuracy with which the regression equation can predict values on the criterion variable, making it more than just curve-fitting. In modern finance, it is used extensively to generate alpha and beta when comparing two issues.

Semi-log

Semi-log refers to the price scaling on charts. The abscissa axis is normally the date axis, so it cannot be displayed logarithmically. Logarithmic scaling shows percentage moves in price and is much better for viewing longterm data. (Note: You cannot use semi-log scaling with any values of zero or negative numbers.)

Smoothing

This is in reference to averaging data either by a simple or exponential moving average. It is a better adverb to use than always trying to explain that you take the moving average of it or take the exponential moving average of it; just say you are "smoothing" it. It is also used as a verb, i.e., you "smooth" it.

Stop loss

Also known as a protective stop, this is a process in which an investor protects herself against losses larger than desired. There are many types of stop losses, such as a percentage drop from the buying price or a percentage drop from the current or highest price reached.

Support and resistance

First, the definitions of support and resistance, then an explanation as to what they are. More elaborate definitions are available in almost any text on technical analysis. In fact, one of the best discussions of it is in Steven Achelis' book Technical Analysis from A to Z, where he ties it to supply and demand. Support is the price at which an issue has trouble dropping below. Resistance is the price level that it has trouble rising above.

Trendiness

This is my term for a market or any price series to maintain a trend. Of course, the trend must be defined by not only its magnitude but also its duration. An upcoming chapter deals with trending markets, and this term is used considerably in that chapter.

Trough

Trough is terminology referring to a low point in prices, usually easy to identify if looking at a price chart, but does depend upon the time frame you are working with. See Peak.

Volatility

Volatility is a measure of the movement of a time series, usually of price data, but is not restricted to that, however. There are many forms of volatility and there is an entire section in this book that discusses it.

World of Finance

This is a term I use to include financial academia and retail (sell side) Wall Street. There is much in this book that is critical of the world of finance.

There are other terms throughout the book, and when I think they need to be defined, the definition is presented on the first appearance of the term.

Living in the Noise

I'm constantly amazed at the media's attempt to justify every move in the market with something in the news, whether it be economic, political, monetary, or whatever. If the market is up over the past hour, they find a positive news item to justify it. If the market is down, then a negative news item is used. There are other ongoing and constant drumbeats of useless information droning throughout the day while the market is open. Some are just plain wrong, such as "the market is down today because there are more sellers than buyers." It is a free trading market, so for that to work, there has to be the same number of buyers and sellers, no matter what the market is doing. They would be correct if they said that the market sold off today because there was more selling enthusiasm. And finally, there is the endless supply of questions for the experts.

Here are some other examples of noise:

"Stocks are under pressure"—Why? "More sellers than buyers"—Impossible on a share basis. "What is causing this decline today?"—Always seeking a reason, rarely correct. "How do you think the market will end this year?"—Forecasting is a fool's game. "The earnings beat expectations, and the stock is down two points"—Sad. "Cash on the sidelines"—How can that be? When you sell a stock, someone has to buy it. "The latest survey says..."—Who cares? "Breaking news"—It wouldn't be news if it wasn't breaking. "Countdown clocks"—Media fascination with investors' fear. "Fair value on morning futures"—Waste of time. "Sorry, Pope Benedict, we have to cut you off because earnings reports are coming out"—Pathetic. "Asking a longtime buy-and-hold manager what he thinks of the market"—Hmmm, let me guess. "Brokerage firms offering magical technical analysis software to open an account"— It's the farmer, not the plow.

Data

I used a great deal of stock market data in this book, primarily the daily series for the Dow Jones Industrial Average and the S&P 500. Reliable data is very important for proper analysis. I have seen references to stock market data back to the early 1800s, but it was spliced together from numerous sources, usually by academics who I think just don't have the same appreciation for accuracy as I do. The two series I used most often have been in existence with original source since the start date of the data I used. Below is some information about the data used in this book.

S&P 500: My series began on December 30, 1927. From the beginning until March 3, 1957, it was the S&P 90. There is, however, older data produced by the Cowles Commission going back to 1871.

Dow Industrials: My series began on February 17, 1885, but records show that Charles Henry Dow began the series on July 3, 1884. While Charles Dow began publishing his series in 1897, he maintained the data from 1885. Following the introduction of the 12-stock industrial average in the spring of 1896, Dow, in the autumn of that year, dropped the last nonrailroad stocks in his original index, making it the 20-stock railroad average. Initially, the data was known only as the Dow Jones Average. In 1916, the industrial average expanded to 20 stocks; the number was raised again, in 1928, to 30, where it remains today.

Shiller PE and CPI data were obtained from Robert Shiller's website. This is monthly data back to 1871 and is updated periodically. Keeping the data updated is also an important part of analysis; the data sources must be reputable. I use Bloomberg, Thomson Reuters, and Pinnacle Data, and I would comfortably recommend them to anyone.

This book is not and never was designed to be a storybook to be read from beginning to end, but is a compilation of information about the markets, the flaws of modern finance, uncovering market history, misconceptions used to promote or market a flawed strategy, and a host of other tidbits. It takes almost two-thirds of the book to get to the "meat" of the book: rules-based trend-following models.

Furthermore, I think a money manager who follows a benchmark or particular style, whether managing funds or separate accounts, is never asked "why" they manage money that way. Simply put, if you are trying to at least track or outperform a benchmark, no one will ask why you try it that way. This is where a rules-based trend-following model, which is almost totally unconstrained in what to invest in and especially treats cash as an asset class, is completely different. Much of this book is about why I use a rules-based trend-following process.

Modern financial theory wants you to believe that the markets do not trend, are efficient, and, therefore, cannot be exploited for profit. They state that it is random and is normally distributed except for some very long-term periods that last many decades. What they ignore is that the market is made up of people, frail humans who act and invest like humans. Humans can be rational and they can be irrational, rarely knowing which is present and when. Being rational at times and being irrational at times is normal. This is not random behavior and is quite predictable. Hopefully, this book will effectively demonstrate those failings and offer a solution.

Another focus of this book is the subject of risk. There is a great story about the simplicity of risk analysis told by the late great Peter Bernstein in his book, Against the Gods. Blaise Pascal, in scribblings in the margin of his Pensees publication, puts for what is now known as Pascal's Wager. He asks, "God is, or he is not. Which way should we incline? Reason cannot answer." He explained that belief in God is not a decision. You cannot awake one morning and declare, "Today I think I will decide to believe in God." You believe, or you do not believe. Pascal leads us through a decision path that ultimately says that if there is not a God, then it doesn't matter. However, if there is a God, then the decision on how to live your life is important. Salvation is clearly preferable to eternal damnation; the correct decision is to act on the basis that God is. (B7)

I have sprinkled many quotes throughout this book. I like quotes because if something someone has said lasts over the years or is repeated often, it is probably profound. This is not unlike trite expressions, which I believe exist because they are generally true whether you want to believe them or not.

I give a lot of presentations/speeches, and each time, I learn something. One thing I learned a few years ago is that if you want to present some serious information to an audience that might just not understand your concepts or that resists anything that is new, use humor sparingly. The humor needs to be simple and essentially just witty, but not overly so. You must get them to uncross their arms and smile; this seems to improve their hearing. I have buried a little of that in this book—I think.

Throughout this book—in fact, throughout most of my life—I have had a tendency to explain things using multiple approaches in the hope of covering a broader audience. In fact, you'll soon learn that I can beat a horse to death at times. If you grasp a concept I am explaining early, please accept my apologies for the remaining explanations.

Finally, here is a short comment about observable information versus actionable information. Often, the world of finance will produce very convincing data or charts that show historical information about the markets. The problem is that they are trying to convince you that you should invest a certain way based on the data they have shown. Usually, and more often than not, the data just shows you past market history and is really only observable information because you cannot turn that knowledge into an investment strategy or idea. Actionable information, on the other hand, is data or charts that show realistic information and can be converted into a valid investment strategy. Do not misunderstand this; observable information is about studying the past and learning about the markets, which is invaluable. However, it takes actionable information to make investment decisions.

Thanks for reading this far. I intend to publish one article in this series every week. Can't wait? The book is for sale here. Next up: Common fallacies investors like you are told.